When it comes to investments, most individuals consider and opt for investing in stocks, mutual funds, and bonds. On the other hand, big-time investors and some companies build stronger portfolios by using private equity and hedge funds. Although their investor profiles are quite similar, there are significant differences between a private equity fund and a hedge fund. In this article, we’ll take a closer look at these differences.
Private Equity Vs. Hedge Fund: An Overview
When a firm or high net-worth individuals invest in privately held companies or those not listed on any stock exchange, it’s known as private equity. They are closely similar to venture capital firms since they invest in companies. While investors primarily purchase private companies, they also sometimes seek controlling interest in publicly traded firms via stock purchases.
Meanwhile, a hedge fund refers to a type of fund that pools money from various firms and high net-worth individuals into financial instruments to produce favorable returns with various techniques and strategies. Essentially, its goal is to provide the highest ROI as quickly as possible. To do that, hedge funds primarily use highly liquid assets that enable the funds to take profits quickly on one investment and move the funds into another more promising investment.
The 5 Differences Between A Private Equity And A Hedge Fund Investment
In this section, we’ll take a closer look at the key differences between a private equity fund and a hedge fund investment to help you choose the right investment for your goals.
Control Of Assets
With a private equity investment, investors have a greater amount of control over the entities or companies that are owned by them in terms of redesigning or changing business strategies, making operation improvements, and implementing governance.
Meanwhile, hedge funds offer little to zero control over the companies and portfolios they invest in. Generally, it is up to fund managers to invest their money in virtually anything that they see the potential for high returns in a short period.
Since hedge funds invest more in liquid assets, investors can withdraw their investments and get their funds at any time. Also, as mentioned before, hedge funds aim to provide the highest ROI as quickly as possible.
Meanwhile, private equity funds have a long-term focus. It usually dictates that an investor needs to commit their funds for a minimum period, typically at least 3-5 years. However, some investments would require up to 10 years.
Both private equity and hedge funds have significant risk and practice risk management. However, private equity often has a lower risk compared to hedge funds. The reason behind this is hedge funds generally focus more on earning higher returns in the short term, which necessarily involves accepting a higher level of risk.
Private equity funds are a close-ended type of investment. This means that new money can’t be invested after the initial period has expired. Its structure follows after the fact that its current market can’t be easily transferred or determined for a certain period.
In contrast, hedge funds are open-ended. It follows the fact that there are no restrictions on the withdrawal and transferability of the funds. Plus, the assets involved in hedge fund investments have high liquidity and are often market to market. This means that investors can add or withdraw their shares in the fund as they see fit.
Fee Structure And Compensation
Lastly, there’s also a difference in the fee structure and how investors are compensated between private equity and hedge funds. For instance, the fees for a hedge fund investment are generally based on the concept of a high water mark. This watermark refers to the difference between the Net Asset Value (NAV) and the rise and fall year-over-year.
For instance, suppose you invested in a hedge fund where the NAV was USD$500 at the time of investment. And perhaps, over the year, it rose to USD$550. The hedge fund investment would then have a USD$50 incentive. However, if it fell to USD$430 and rose back to USD$480, the hedge fund wouldn’t have any incentive since the high-water mark of USD$500 wasn’t broken.
On the other hand, private equity investors are charged 2% for management fees along with 20% incentive fees. Furthermore, instead of a high watermark, PEs have a hurdle rate. Essentially, the funds could earn incentives if this rate gets crossed. For instance, if the hurdle rate of the investment is 10% and the annualized return is only 8%, there won’t be any incentive fee. However, if the annualized return reaches 12%, the investor is charged the incentive fee on the full 12% return.
While both private equity and hedge funds appeal to high-net-worth individuals, they have their respective differences, especially in how they operate. And with that, the right one for your needs will depend on your investment goal and portfolio.
To summarize, private equity funds lean towards long-term investments in illiquid assets. Conversely, a hedge fund is more focused on the short-term with liquid assets that can be easily converted into cash and provide better control over the business.